Workday Surfing The SaaS Wave

Emerging ERP vendor Workday (Nasdaq:WDAY) is one of the most expensive names in the software space today, as investors are seemingly happy to pay huge multiples for shares in a company that many believe can seriously challenge large incumbents like Oracle (Nasdaq:ORCL), SAP (NYSE:SAP), and Microsoft (Nasdaq:MSFT). So long as the company can continue to deliver growth ahead of demand expectations, the party will most likely continue and it won't surprise if Workday's shares hit three digits at some point in 2013. That said, this is a story where valuation leaves no margin for error, so investors should understand what they're getting into before buying shares.

Beating The Revenue Marks For Q2
Expectations for Workday these days are pretty simple – grow subscriptions, billings, and other revenue metrics. And the company did just that this quarter, as revenue growth of 72% (17% sequential) beat the average estimate by about 7%. Deferred revenue rose 32%, billings rose 36% (against a 23% average estimate), and short-term billings rose 61% (against a 53% estimate).

At this point margins are largely an afterthought. GAAP gross margin did improve (and by about seven points), but I just don't think that's what the Street is going to care about right now. Likewise, a sequentially smaller operating loss sounds nice and all, but I would suspect that many investors would have rather seen the company hit its hiring targets and post a larger loss.

Incremental Data Sounded Positive
Management gave a few tidbits of information, but seemed to be holding off on more detailed discussions ahead of the upcoming analyst day (September 10). Concerning the company's position in the Financial side of the ERP market, management saw more mid-market wins and multiple replacement wins against Microsoft. Management also indicated that they're not encountering NetSuite (NYSE:N) in the market all that often, as NetSuite is targeting a different segment of the market today.

Gaining Share Rain Or Shine
This hasn't exactly been the strongest summer on record for the enterprise software market, but Workday continues to grow well ahead of the estimated single-digit market growth. With a SaaS model that significantly reduced the total long-term cost of ownership, Workday offers a pretty compelling valuation proposition relative to large vendors like Oracle and SAP, as well as a strong suite of capabilities that many smaller vendors struggle to match.

The real question now is how successfully management handles and manages the growth. The company has a new “Big Data” module coming out, and Workday is still only a small player in its core Human Capital Management and Financial markets. If the founders of Workday can match what they accomplished at PeopleSoft, the company could well be on its way to becoming 5% of the market in a few years, with significant revenue growth along the way.

As mentioned earlier, though, one of the challenges for the company will be building to support that growth. Identifying, hiring, and bringing talented new workers on board takes time and money and Workday may well find itself limited by talent availability, HR throughput capacity, and near-term cash flows (though a recent bond offering should more than cover that).

The Bottom Line
I won't try to argue that valuation doesn't matter with a stock like Workday, but the reality is that crafting a model/scenario that makes Workday look cheap borders on the impossible. As the markets have shown time and time again, though, investors will pay huge premiums for strong growth stories and that's what Workday offers right now. There will be a day of reckoning at some point, brought about either by a miss on reported growth or even just evidence of meaningful deceleration, but waiting for that day will likely prove frustrating for those who believe they can hold off and buy Workday later at a more “reasonable” valuation.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.